High inflation and rising interest rates caused many investors to shun growth stocks in favor of safer assets in 2022. Even competitively advantaged and profitable enterprises like Etsy (ETSY 3.43%) were punished. With economic uncertainty remaining high, there are opportunities for long-term investors to scoop up great businesses at discounted valuations.
As of this writing, Etsy's shares are down 62% from the all-time high they set in November 2021. This means the stock might look like a good buy right now. Here's why.
The pandemic's effects
While some industries were seriously punished by the coronavirus pandemic, others absolutely thrived. With consumers spending more time than ever at home, the e-commerce sector boomed. And Etsy benefited tremendously.
Some consumer demand was certainly pulled forward in 2020 as people flocked to the platform. But what's encouraging to see is that Etsy hasn't given up its gains. The company's gross merchandise sales (GMS) of $13.3 billion in 2022 were 166% higher than its pre-pandemic 2019 total of $5 billion. Even more impressive is that Etsy now boasts more than 95 million active buyers and 7.5 million active sellers, up from 46.4 million and 2.7 million, respectively, as of the end of 2019.
GMS declined by 1.3% between 2021 and 2022 as consumer behavior began to normalize and shoppers started to move more of their spending away from physical goods and toward services, experiences, and travel. But Etsy showed that it can extract higher fees from the activity that occurs on its marketplaces, as revenue last year increased 10.2% year over year.
Shareholders today are keenly aware of the impact that macroeconomic conditions are having on the company. But thanks to Etsy's incredible ability to consistently produce free cash flow, it will have no issue weathering the storm.
Differentiation is a strength
Etsy operates a successful business model thanks to two important factors. One is its asset-light nature. Etsy simply allows buyers and sellers to transact with each other -- it does not purchase or store any inventory itself. This means that its cash is not tied up in merchandise. That model also allows the company to scale well. Between 2016 and 2021, Etsy's operating margin expanded from 5.1% to 21.6%.
Another important characteristic of Etsy is just how differentiated its marketplaces are. According to a survey conducted by the company, 87% of shoppers said Etsy had products they couldn't find anywhere else. This simple data point exemplifies how valuable a shopping destination it has become for consumers. And it's easily one of Etsy's key strengths.
A bright future
Although Etsy's gains between 2019 through 2022 were nothing short of spectacular, management believes that the company's growth days are far from over. It estimates the company's total GMS addressable market at $466 billion (for relevant product categories within online shopping). Based on that, Etsy currently commands a tiny 2.9% market share.
Zooming out, e-commerce penetration is still pretty low here in the U.S. According to data provided by the Federal Reserve Bank of St. Louis, e-commerce accounted for 14.7% of overall retail sales domestically in the fourth quarter last year. There is clearly still a huge runway for that percentage to march higher over time.
In addition, in this period of high inflation and economic volatility, more people might be inclined to try to find extra sources of income to make ends meet. And selling items on Etsy seems to be a reasonably popular way to make some extra cash. I'm unsure if its leadership team has made any mention of this as a potential growth driver, but it makes sense conceptually.
Moreover, because Etsy's marketplaces focus more on discretionary merchandise, like home furnishings, jewelry, and clothing, when the economic picture takes a turn for the better, it's easy to make the case that the business will post strong gains once again. Investors just have to be able to ride out the near-term uncertainty so they can be in position to reap the potential benefits later on.
With the stock down big since it peaked over a year ago, it's selling at a forward price-to-earnings ratio of 27. That's not too demanding a valuation when you consider that the consensus estimate of Wall Street analysts is that its free cash flow this year will be greater than $1.1 billion, compared to $653 million in 2022. As a result, investors might want to add Etsy to their shopping carts.
